The governance of banks in transition economies Georgia country report
2012
Table of content
Table of content ...... 2 Foreword ...... 3 A. Methodology and overview of the banking system in Georgia ...... 4 1) Methodology ...... 4 2) Overview of the banking sector in Georgia ...... 4 Executive summary ...... 8 3) Legal framework ...... 8 4) Supervisory practice...... 9 5) Bank practice...... 10 6) Key recommendations ...... 12 7) Overall assessment of bank governance quality in Georgia ...... 14 C. Analysis of the strengths and weaknesses of the corporate governance of banks in Georgia ...... 17 8) The strategic and governance role of the board ...... 17 9) Composition and functioning of the board...... 21 10) Risk governance ...... 27 11) Internal control ...... 30 12) Incentives and compensation ...... 34 13) Transparency to the market and regulators ...... 35
This Report does not constitute legal advice. Readers are advised to seek appropriate legal advice before entering into any transaction, making any determination or taking any action related to matters discussed herein. The contents of this Report are copyrighted. The assessments and views expressed in the Report are not necessarily those of the EBRD. All assessments and data in the Report are based on information gathered in the course of 2011.
For information or comments please contact Gian Piero Cigna at [email protected]
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The team is grateful for the assistance provided by all parties interviewed. In particular, the team would like to acknowledge the precious assistance offered by Eristavi Law Firm (http://www.elg.ge) and Begiashvili & Co. Limited (http://bco.ge).
Georgia Country Report – 2012 PAGE 2 of 37
Foreword
In 2011, the Legal Transition Team of the EBRD launched a comparative assessment of the corporate governance of banks in its countries of operations. The overall objective of the assessment is to inform and support the EBRD’s policy dialogue with authorities with a view to generating further commitment to improve the corporate governance of banks in EBRD countries of operations. The assessment aims at providing the EBRD with an overview of the legal and regulatory framework governing the corporate governance of banks and how diligently the various rules and best practice guidelines are implemented.
The assessment focuses mostly on internal corporate governance arrangements in banks, particularly the role and composition of boards. It analyses the legal and regulatory framework; its implementation by supervisors; and the practices developed by the largest, more systemically important banks in each country. The transparency of governance arrangements to the supervisory authority and the markets is also reviewed. While the assessment analyses banks and their boards, and considers ownership structure and patterns in the banking sector, broader governance issues covered in the OECD principles such as shareholder and stakeholder rights and responsibilities as well as equity market issues are not dealt with in any detail.
To enhance the EBRD’s understanding of the corporate governance of banks in countries of operations, countries reviewed are subjectively rated. For this purpose, the legal framework, supervisory practice and banking practice are given an overall score in the executive summary section of each country report. In addition, the performance of countries in the key areas mapped out in the EBRD checklist is also rated and included in the executive summary section of each country report. The rating approach is detailed in the box below.
Rating “Strong to very strong” - The corporate governance framework / practices of supervisory authorities / practices of banks are fit for purpose and are close to best practice. “Moderately strong” - Most parts of the corporate governance framework / practices of supervisory authorities / practices of banks are adequate but further reform is needed “Weak” - The corporate governance framework / practices of supervisory authorities / practices of banks contain some elements of good practice but overall the system is in need of reform “Very weak” - The corporate governance framework / practices of supervisory authorities / practices of banks contain significant risks and are in need of significant reform
Each country report is divided into three sections: (A) Methodology and overview of the banking system; (B) Executive summary; (C) Analysis of key strengths and weaknesses of the corporate governance of banks and policy recommendations where appropriate.
Georgia Country Report – 2012 PAGE 3 of 37
A. Methodology and overview of the banking system in Georgia
1) Methodology
1. The analysis and recommendations contained in this report are based on research carried out by the EBRD and responses to written questionnaires sent to one Georgian law firm; the National Bank of Georgia; the Georgian Association of Banks and three among the larger banks in the country. Responses to the questionnaires were complemented by face-to-face interviews carried out in Tbilisi in March 2011 during which the EBRD assessment team met with respondents to the questionnaires, as well as representatives of the Georgian Stock Exchange.
2. Based on best practice assessment checklist, the questionnaires and interviews inquired about the legal and regulatory framework on bank governance, supervisory practice and the practice of banks in Georgia. In 2001, the largest banks in Georgia - measured by their share of the total assets of the country’s banking system - were the Bank of Georgia, TBC Bank; Procreditbank, Liberty Bank and Bank Republic (Groupe Société Générale). Together, they controlled 81.81% of the total assets of the Georgian banking system (see Exhibit 1, below).
Exhibit 1: The five largest banks in Georgia by share of total banking assets
Total Assets in Share of total asset Bank name (5 largest banks) Listings thousands GEL* of banking system 1. Bank of Georgia 4,665,261 36.79% GSE (List A) and LSE 2. TBC Bank 3,300,021 26.03% No 3. Procreditbank 971,846 7.66% No 4. Liberty Bank 733,235 5.78% GSE (List B) 5. Bank Republic (Groupe Société Générale) 702,450 5.54% No Total 5 banks 10,372,813 81.81% Total banking system 12,679,084 100% Source: 2011 Annual Consolidated Account of Banks1
2) Overview of the banking sector in Georgia
3. As of December 31, 2011, the Georgian banking system comprised 19 banks of which 17 are resident banks and 2 are branches of foreign banks. The total assets of the banking system amounted to GEL 12.679bn (approx. EUR 5.86bn)2 and constituted 52.3% of GDP. Foreign capital participation is present in every Georgian banking institution. As of February 2012, the share of non-residents in the banks’ paid-in capital equalled 85.6%.3
1 Information about total assets of the banking system may be found at: http://www.nbg.ge/index.php?m=306 (Assets and Liabilities of the Commercial Banks); and the information about the each individual bank may be found at: http://www.nbg.ge/index.php?m=404 2 At 30/12/2011, the exchange rate EUR/GEL was 1 EUR = 2.163 GEL (see http://www.freecurrencyrates.com/exchange-rate-history/EUR-GEL/2011) 3 Source: National Bank of Georgia, Annual Report 2011 (http://www.nbg.ge/uploads/publications/annualreport/2011/annual__eng_2011_webnew0309.pdf)
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4. Banks are organised as joint stock companies under a two-tier system where the general meeting of shareholders (‘GMS’) appoints the supervisory board ('SB', or 'board') members and, in turn, the SB appoints the management board members ('MB').
5. As the National Bank of Georgia pointed out in its 2011 Annual Report, the banking sector is represented by powerful strategic investors, including large European and regional banking and international financial institutions. The supervisor is confident that such large representation contributes extensively to the promotion of good corporate governance practices and competitive domestic market. This reliance, however, must not displace the local authorities and stakeholders’ continuous effort to further promote goods corporate governance practices.
6. Macroeconomic performance has been strong in the past two years. Output expanded by around 7 per cent in 2011 and at a similar rate in the first half of 2012. Growth has been sectorally broad-based with manufacturing, financial services and tourism among the main contributors. The central bank was able to loosen monetary policy by decreasing the refinancing rate from the peak of 8 per cent in June 2011 to 5.5 per cent in November 2012. Although the current account deficit rose to 11.8 per cent of GDP in 2011, rising private inflows caused appreciation pressures and enabled the central bank to replenish external reserves. The share of non-performing loans (NPLs) in the financial sector has declined steadily, to 7 per cent of total loans at end-March 2012. The general government deficit declined to 3.6 per cent of GDP in 2011. The authorities have been able to reduce reliance on official external financing, while maintaining a precautionary arrangement with the IMF.
7. The country’s successful stabilisation and recent performance have been recognised by the markets. Several international rating agencies upgraded their ratings of Georgia’s sovereign debt. The risk premium paid by the country narrowed to around 400 basis points as of July 2012. The national railways company, Georgian Oil and Gas Corporation and Bank of Georgia have been able to tap international markets. However, an international placement of the national railways’ shares, scheduled for May 2012, had to be postponed in light of the difficult financial markets environment. However, the uncertain global environment warrants continued engagement with IFIs. The short-term macroeconomic outlook is positive as broad-based growth is expected to continue at fast pace, benefitting from credit expansion, public and private investment and remittances. At the same time, the current account deficit remains large (at 11.8 per cent of GDP in 2011) and the financial sector is heavily dollarised. The stock of external debt and rollover needs are high for an emerging market economy. The new stand-by arrangement with the IMF would ensure the country’s high current account deficit can be financed, should private sector flows reverse, and exchange rate movements can be smoothed to avoid destabilising the financial sector. The international financial crisis highlighted important weaknesses in the financial sector. Strengthening of banking sector, improvements in risk and portfolio management including through increase in local currency lending, as well as improvements in supervision and confidence in the banking sector, are important for financial sector stability.4
8. The National Bank of Georgia (‘NBG’) is the banking supervisory authority, responsible for ensuring public trust in the banking system and protecting stability in the banking sector. In addition, improved focus has been placed on macro-prudential supervision methods. The NBG is keen to shift the focus to the risk-based supervision and undertakes on- and off-site initiatives to this end.
9. According to the NBG, the 2008-2009 economic crisis led to deterioration of banking loan quality, thereby increasing loan provisioning costs. Concurrently, the costs related to attracting
4 Strategy for Georgia, 2010, EBRD, see at: http://www.ebrd.com/downloads/country/strategy/georgia.pdf
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deposits and the share of liquid assets went up, adversely affecting the banking sector’s profitability. Starting from 2010, the situation reversed with banking sector’s profitability considerably improving, with the return on assets (ROA) and the return on equity (ROE) amounting to, respectively, 1.7% and 9.6% at the end of the year. The net profit in 2011 equalled GEL 323 million (approx. EUR 149.3 million), more than twice exceeding the 2010 level (GEL 156 million, approx. EUR 72.12 million)and resulting in acceptable profitability indicators: return on average assets equalled 2.85%, while the return on average equity stood at 17.3%. As of end-2011, tier 1 and regulatory capital adequacy ratios stood at 11% and 17%, exceeding the respective required levels by 3% and 5%. The regulatory capital adequacy requirement stands at 17% for the NBG’s methodology and at 26% according to Basel I requirements, exceeding the analogous indicator of many other countries.
10. With the view to adopting risk-oriented supervision, in September 2011 the NBG announced Basel II/III implementation plan. This implies calculation of required capital based on more detailed analysis of individual banks’ risk profiles. Transition to Basel II/III is planned starting from 2013.
11. In 2010, one commercial bank, the “Iberiabank ltd” was liquidated and removed from the bank register. This follows the liquidation of “Georgian Post Bank”, “Georgian Maritime Bank”, “Ivertbank” and “Agroinvestbank”, in the preceding years.
12. Currently, there is no depositor’s protection scheme in Georgia and it does not appear that the government is considering adopting one.
13. The Georgian Stock Exchange (‘GSE’) was officially recognised as a self-regulatory organisation and obtained a stock exchange license in January 2000. The GSE is the only organised securities market in Georgia, and has been regularly trading since March 2000. As of February 2011, 138 companies were traded on GSE, with total market capitalization of about USD 1.1 billion, but with very little liquidity and actual trading amounting at an average daily turnover of USD 9,9495. Out of the five largest banks in the country banks, Bank of Georgia and Liberty Bank are registered and listed on the GSE. All other reviewed banks are closed JSC, not listed on any stock exchange.
Exhibit 2: Laws and regulations on the corporate governance of banks in Georgia6
Law on Entrepreneurs: Adopted in 1994, it regulates the formation, organisation and dissolution of joint stock companies, including banks. The law sets out the basics for corporate governance, describing the governing bodies of companies and their responsibilities. The law allows companies (up to a maximum of 100 shareholders) to adopt either the one or two tier governance systems. However, this option is not available to banks, which must be organised under a two-tier system according to the Law on Activity of Commercial Banks. Law on Activity of Commercial Banks: The law was adopted in 1996 and deeply amended since then. It regulates the activity of banks, their structure and all aspects of banks licensing. The law requires the two- tier governance system for banks. The law contains basic requirements for members of the supervisory board, management and audit committee. In an attempt to deregulate the market many provisions on responsibilities of the governance bodies were removed. Law on National Bank of Georgia: The law was issued in September 2010 and establishes the rights and
5 Source: http://www.privatebanking.com/user/extra_info.jsp?location_id=5454&category_id=63&account_id=102272&p ublished=1&page_id=0&.rnd=1cf773baa5564fbb989a62da6dc32588 6 The text of the main laws and regulations listed below is available at http://www.nbg.ge/index.php?m=178
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powers of the National Bank of Georgia as regulator and supervisor of the banking sector in Georgia. Regulation on Fit and Proper Criteria for Administrators: The regulation was issued in September 2002 and sets out detailed fit and proper criteria for senior management, chief accountants and heads of branches of banks but it does not apply to the members of the supervisory boards and audit committees. Regulation on Risk Management in Commercial Bank: The regulation was issued in March 2008 and establishes principles for effective risks management in order to enable the bank’s management to reveal in a timely fashion potential losses and their adverse impact on the bank’s capital. Regulation on Capital Adequacy Requirements for Commercial Bank: The regulation was approved in 2002 and sets out regulatory minimum capital, risk capital ratios, types of risk and relevant risk ratios. Regulation on Conflict of Interest and Transactions Between Bank Administrators and Related Parties: The regulation was approved in 2001 and details the mechanisms to be followed in transactions with conflict of interest, prohibits certain behaviours of the bank administrators. Regulation on Internal Audit Requirements for Commercial Banks: The regulation was approved in December 2011 and sets the internal audit requirements for the purposes of developing accounting, reporting, risk management and internal control systems in commercial banks. Regulation on Transparency of a Commercial Bank Financial Condition: The regulation was approved in 2006 and establishes the obligation for banks to publish their financial statements in compliance with the IFRS and details the ratios banks must make available to the public. Corporate Governance Code for Commercial Banks: Developed by the Association of Banks and adopted in 2009. It includes recommendations on shareholders rights, supervisory and management boards, corporate secretary, internal control and risk management, information disclosure and transparency, conflict of interest and corporate governance of holdings. It is to be applied under the so called “comply or explain” mechanism, according to which banks should either comply with the proposed recommendations or explain the reasons for non-compliance. 12 banks have undersigned to the code but none publish any reports in relation to the code.7
7 The code is available at http://www.ebrd.com/pages/sector/legal/corporate/codes.shtml
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Executive summary
3) Legal framework
Key strengths
14. Georgia has developed the main legal tools for regulating corporate governance of banks. The country has adopted a comprehensive company law and a banking law which regulates licensing and operational activities of banks. The regulatory framework sets out detailed requirements for experience, education and quality of the senior management of banks.
15. With the adoption of Decree no. 71 On Approving Regulation on Risk Management in Commercial Banks (“Regulation RM”) and the Regulation on Internal Audit (“Regulation IA”), the country has established a regulatory framework on internal control and risk management in financial organisations. These acts set out a number of requirements for risk management, highlighting the need for a separate risk management function that should implement bank risk strategy. The regulations stress the need for an independent internal audit function that must review internal control systems and report any potential and existing problems, as wells as issue recommendations and follow up on their implementation.
Key weaknesses
16. In an attempt to deregulate the market and provide market participants with the necessary flexibility, the legislators have left the functions and responsibilities of the supervisory board (in the mandatory two-tier structure) primarily to the discretion of banks. The law does not detail the division of authority and responsibility between the SB and MB. In particular, the board is not expressly entrusted with the authority to approve the bank’s strategy, risk strategy and risk appetite, annual budget and to monitor their implementation. As a result, banks' practices vary, with some delegating most of the responsibilities to the management and others primarily relying on the instructions coming from the parent/group. Keeping in mind that the legal framework imposes a mandatory two-tier structure, it would be appropriate for the banking regulations to emphasise the strategic role of the supervisory boards and to create a level playing field in the distributions of responsibilities between the board and the senior management based on best international practices.
17. The framework does not provide guidance on the composition of the supervisory board, its committees and their role. The law does not set any expertise requirements in relation to the supervisory board members and does not require the presence of independent directors on the board. The Corporate Governance Code for Commercial Banks includes a definition of independent member of the supervisory board, but in practice there is no evidence of the Code’s implementation8. These issues may impair the capacity of the board to decide on the strategic issues, its ability to exercise objective judgment and to uphold the independence of the risk and internal audit functions.
18. The law requires banks to set up an audit committee (“AC”), but does not establish any requirements regarding its composition. As a result, in some banks the audit committee is not a board committee but a separate body, which may include outside members, who are not subject to duties of loyalty and care to the bank. Moreover, there is no requirement that audit committees should include independent directors. The lack of clarity of the committee’s
8 See Chapter 2, letter c) and e) of the Corporate Governance Code for Commercial Banks.
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composition can undermine its role of being the reference point for an independent risk management and internal audit function and of providing the board with the necessary objective judgement in the analysis of issues potential for conflicts of interests.
19. The banking legal framework does not expressly require banks to establish a compliance function as part of the internal control system. As a result, banks generally do not have such function in place. In the few cases where this function exists, it deals only with anti-money laundering issues. Instead, the role of the bank’s compliance function should be to assist senior management in managing effectively the “compliance risk”9 faced by the bank.10
20. Banking regulations fail to provide an operational framework for the implementation of the Corporate Governance Code for Commercial Banks. Consequently, the Code is merely declarative in nature and bears no weight on bank practices. The “comply or explain” approach expounded by the Code remains on paper and banks do not report on their implementation of the Code’s recommendations.
21. The banking law and regulations do not require that at least systemically important banks disclose in their annual reports and on their websites information on their management bodies, governance structure, risk management and ownership structure. Although the Corporate Governance Code contains a comprehensive section on information disclosure and transparency, as mentioned above, this is not implemented.
4) Supervisory practice
Key strengths
22. The fundamentals of a supervisory framework have been established to oversee the activities of financial institutions. The National Bank of Georgia (‘NBG’) is the authority responsible for granting and withdrawing banking licences; adopting banking regulations and supervising regulated entities. The supervisor approves the candidates for banks’ management boards and verifies their knowledge and experience. The NBG aims to primarily use soft law leverages in order to arm banks with the necessary flexibility in deciding their structure and division of responsibilities.
23. Equally, the NBG is keen on ensuring that banks adhere to best practices in risk management and it regularly reviews banks’ risk profiles. The NBG monitors banks’ management risk function during on-site inspections and through desk reviews and regularly meets with the bank risk departments.
Key weaknesses
24. The banking framework comprises limited fit and proper tests for members of the supervisory board and audit committee. The NBG does not approve the appointment or review the
9 Compliance risk can be defined as the current and prospective risk to earnings or capital arising from violations of, or non-conformance with, laws, rules, regulations, prescribed practices, internal policies, and procedures, or ethical standards. Compliance risk also arises in situations where the laws or rules governing certain bank products or activities of the Bank’s clients may be ambiguous or untested. This risk exposes the institution to fines, civil money penalties, payment of damages, and the voiding of contracts. Compliance risk can lead to diminished reputation, reduced franchise value, limited business opportunities, reduced expansion potential, and an inability to enforce contracts. 10 See Basel Committee on Banking Supervision Compliance and the compliance function in banks April 2005, available at http://www.bis.org/publ/bcbs113.pdf
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adequacy of supervisory board members and audit committee individually and as a whole. In view of the growing complexity of the banking sector and the strategic role of the supervisory board, international best practices recommend that supervisors should obtain the information necessary to evaluate the expertise and integrity of proposed (supervisory) board members and not only those of senior management.11
25. The local supervisory authority appears to rely to a great extent on the significant presence of International Financial Institutions in the country for promoting and implementing international best practices and ensuring adequate governance structures in local banks. This should be coupled with an active guidance by the local supervisor on the practices that local banks must follow and – in case of subsidiaries of foreign banks - on the balance between foreign and local interests.
26. The framework does not require systemically important banks to submit to the supervisor or to disclose their risk appetite. This limits the supervisor’s capacity to regularly review banks’ overall risk strategies and take preventive measures that may be necessary to ensure the safety and soundness of the bank or the financial system.
27. Overall, the supervisory authority involvement in monitoring the effectiveness of banks’ internal control systems seems weak. The supervisor does not meet regularly with audit committee members and does not scrutinize the appointments of the head of internal audit, chief risk and the chief compliance officers.
28. In line with the NBG plans (see above paragraph 10), the overall practice of regular reporting by the banks to the NBG should be strengthened, as the NBG does not receive: reports on risk along the lines required by Basel II, Pillar III framework detailing the banks’ assessment of their risk profile and their capital adequacy; corporate governance reports; director remuneration reports and reports on the effectiveness of internal control. Such regular reporting would enable NBG to effectively monitor banks' governance practices and timely undertake any remedial actions to address material deficiencies.
5) Bank practice
Key strengths
29. Boards are generally responsible for approving the bank’s annual budget. Boards are generally of manageable size, comprised of less than 10 members. Banks report that they organise induction trainings for board members. There also seems to be no significant government’s influence on banks and on their governance structure.
30. The banks reviewed have set up separate independent risk management function in charge of implementing the risk strategy and reporting to the banks' senior management. Banks have established executive risk committees that meet on a weekly basis. The banks reviewed have also established separate independent internal audit functions, reporting to the audit committee and supervisory board.
11 Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010), §137, see at: http://www.bis.org/publ/bcbs176.pdf
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Key weaknesses
31. Our analysis revealed that boards are not always in charge of the bank strategy approval process. In some cases, management appears to drive the process leaving the board with a merely formal role and therefore undermining its ability to effectively supervise the strategy’s implementation.
32. Some of the systemically important subsidiaries have limited “local” presence on their supervisory board. In this respect, it is important that boards have the ability to address and debate “local” strategy, risk appetite and budget issues. Host supervisors in certain transition economies have adopted language requirements to ensure that systemically important bank boards include at least one director with adequate knowledge of the local market and stakeholders. It is also in the interest of bank boards to include directors who have forged ties with the local supervisor and business communities.
33. Banks adopt inconsistent practice regarding audit committees’ composition and responsibilities. Some of the banks reviewed have set up audit committees which are not board committee and include outside members. Overall, this structure of the audit committee does not appear to have a significant role in banks’ activities and seems to have been created merely for the purposes of complying with regulations.
34. Banks generally do not have a nomination policy and do not perform board evaluations.12 Best practices recommend banks to have “a policy on the nomination and succession of individuals with key functions in the institution” with a description of the process for selection of candidates and of necessary competencies and skills to ensure sufficient expertise in the board.13 To support board performance, the board should carry out regular assessments of both the board as a whole and of individual board members. Either separately or as part of these assessments, the board should periodically review the effectiveness of its own governance practices and procedures, determine where improvements may be needed, and make any necessary changes.14
35. The overall approach to risk oversight is unclear. Our analysis revealed that only few banks have a chief risk officer with sufficient “gravitas” within the bank. Board’s involvement in defining the risk appetite is limited: approval and implementation rests with the management. The risk appetite approach is bottom-up, driven by front office credit officers. In order to avoid the mistakes of the recent past, boards need to have a more thorough discussion of forward looking risk issues and set clear boundaries that management should respect. Without top down risk boundaries to which the board is committed, credit will always be driven by the power of local economic interests over credit officers and committees.
36. At the time when the assessment was made, over 80% of the shareholding of the largest bank in the country (Bank of Georgia) was incorporated in global depository receipts (GDRs)15. Disclosure of GDRs’ beneficial ownership to the National Bank of Georgia is only due when the ownership triggers the 10% threshold. The NBG assumes that it is able to identify the GDRs beneficial ownership when necessary, but it admitted that it has not checked the process yet.
12 For large banks, externally facilitated evaluation from time to time have become a regulatory/Code requirement. 13 See EBA Guidelines on Internal Governance (GL 44), page 24: 14 Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010), page 11. 15 A global depository receipt or global depositary receipt (GDR) is a certificate issued by a depository bank, which purchases shares of foreign companies and deposits it on the account. GDRs represent ownership of an underlying number of shares.
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On 8 March 2012, Bank of Georgia announced its intention to terminate the GDR programme and delist all outstanding GDRs. Still, the issue should be addressed.
6) Key recommendations
37. The following summary of the recommendations contained in Section (C) below aim to address these challenges.
Legal framework
1. The Law on Entrepreneurs and/or banking regulation should guide the division of powers and responsibilities between the board and the management. Strategic decisions (e.g., approval of strategy, budget and risk appetite) and oversight of the management should belong to the supervisory board, while operational matters should be best delegated to the management board.
2. Banking regulations should include appropriate “fit and proper” criteria for supervisory board members and require that supervisory boards include a sufficient number of well qualified independent members. The definition of independence included in the Corporate Governance Code can be taken as a model.
3. The Corporate Governance Code for Commercial Banks should be given proper implementation (e.g., by requiring banks to “comply or explain" the Code’s implementation).
4. The guidance provided by the Corporate Governance Code for Commercial Banks on the role and composition of the board committees should be upheld by the regulator. In addition, the audit committee should be strengthened to include a sufficient number of independent SB members, so as to ensure the integrity of the internal audit function and of financial statements.
5. The Regulation on Risk Management in Commercial Banks should be more specific on the role and responsibility of SB in defining and approving the general risk strategy and risk appetite for the bank.
6. The banking regulations should require banks to maintain a compliance function to support senior management in managing effectively compliance risks.
7. Systemically important banks should be required to disclose information on their management, governance, risk management and ownership structure in their annual reports and on their websites.
Supervisory practice
8. The NBG should require banks to develop a forward looking statement on risk, aligned with the strategy. The risk appetite should be communicated to the NBG.
9. Banks should periodically disclose to the NBG (i) a report on risk along the lines required by Basel II, Pillar III framework detailing the banks’ assessment of their risk profile and their capital adequacy; (ii) a corporate governance report; (iii) a director remuneration report; and (iv) a report on the effectiveness of internal control.
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10. The NBG should be able to have at all time a clear view on the beneficial ownership structure of the banks (even when such shareholding is represented by Global Depository Receipts). Beneficial ownership is key for the market as a whole not only for the supervisor.
Bank practice
11. In line with the recommendations of the Corporate Governance Code for Commercial Banks, “board” committees should be composed only of “board” members. Committees should be able to access outside independent technical advice, when needed.
12. Banks should have on their supervisory boards a sufficient number of persons with local expertise.
13. Banks should develop nomination policies describing the necessary competencies and skills to ensure sufficient expertise in the board.
14. Banks should periodically review the mix of skills in their supervisory boards and consider its appropriateness compared with the bank’s risk exposure and strategy. The skills should enable the board to decide strategic matters, involve in productive discussions and challenge senior management decisions
15. Boards should also carry out board evaluations to assess their effectiveness. Either separately or as part of these assessments, the board should periodically review the effectiveness of its own governance practices and procedures, determine where improvements may be needed, and make any necessary changes
16. Supervisory boards should be in charge of developing and approving the banks’ risk appetite. Banks should appoint a senior officer responsible for managing risk (CRO or equivalent) with direct access to the board.
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7) Overall assessment of bank governance quality in Georgia
38. The following table provides a preliminary rating of Georgia’s performance in the key governance areas mapped out in the EBRD best practice assessment checklist. Rating in this table is subjective and based on the overall assessment of the strengths and weaknesses of the legal framework, supervisory practice and the practice of banks as discussed in section C below. The rating also reflects our assessment of the legal framework, supervisory practice and the practice of banks compared to international best practice standards.16
Issues Score17 The strategic and governance role of the board Strategic role of the board Do boards have an active role in developing and approving the strategic objectives and the Weak budget of their banks? Do boards effectively review and evaluate management performance against agreed budgetary Moderately targets? strong Governance role of the board Do boards effectively shape the governance framework and corporate values throughout their Weak organisation? Moderately Are boards of subsidiaries in a position to effectively control the operation of their subsidiaries? strong Moderately Is there adequate transfer of good practice between parents and subsidiaries? strong Board composition and functioning Size, composition and qualification Moderately Is the size of boards adequate to meet the requirements of their business? strong Are directors qualified for their position? Weak
Is the board independent from management and controlling shareholders? Very Week
Are the duties of directors to their banks, shareholders and stakeholders clearly set out? Weak Is there adequate balance of power between individuals within boards and are there adequate Moderately checks to maintain the balance? strong Do board chairs possess relevant banking and/or financial industry experience and a track record Moderately of successful leadership? strong
16 Best practice standards used in our assessment: Basel Committee on Banking Supervision, Principles for enhancing corporate governance, (2010); Basel Committee on Banking Supervision, Enhancing corporate governance for banking organisations, (2006); EBRD, OECD, Corporate Governance of Banks in Eurasia, (2008); OECD, OECD Principles of Corporate Governance, (2004); European Commission, Corporate governance in financial institutions and remuneration policies, (2010); Institute of International Finance, Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations, (2008); Netherlands Bankers’ Association, Banking Code, (2009) 17 Where: “Strong to very strong” - The corporate governance framework / practices of supervisory authorities / practices of banks are fit for purpose and are close to best practice. “Moderately strong” - Most parts of the corporate governance framework / practices of supervisory authorities / practices of banks are adequate but further reform is needed “Weak” - The corporate governance framework / practices of supervisory authorities / practices of banks contain some elements of good practice but overall the system is in need of reform “Very weak” - The corporate governance framework / practices of supervisory authorities / practices of banks contain significant risks and are in need of significant reform.
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Issues Score17 Do current tenure patterns of board directors suggest a high level of engagement and Moderately independence? strong Moderately Do boards provide adequate induction and professional development to their members? strong Nomination committees
Is director succession and nomination a transparent process? Very Week
Functioning and evaluation Are the responsibilities, authorities, and terms of reference of boards and board committees Weak clearly defined and documented? Do boards function in ways that encourage informed contribution and constructive challenge by Weak all directors? Moderately Do boards meet regularly? strong
Are boards and board committees supported by a senior company secretary? Very Week
Do boards evaluate their performance and discuss the outcome of such evaluation? Weak
Risk governance Risk governance framework Are boards and their risk committees involved in setting the risk appetite and monitoring the risk Weak profile of banks? Do banks appoint and empower senior chief risk officers? Weak
Moderately Do senior executives have an integrated firm-wide perspective on risk? strong Risk committees
Are boards in a position to effectively review risk management? Very Week
Internal Control Internal control framework Does the organisational structure of banks include clearly defined and segregated duties for key Moderately officers and effective delegation of authority? strong Are there enough checks and balances to ensure the independence and integrity of financial Weak reporting?
Are conflicts of interest including related party transactions effectively managed? Weak
Is external auditor independence upheld by boards and their audit committees? Very Week
Moderately Have banks established effective internal audit departments? strong Do banks establish effective compliance departments to ensure that they comply with regulatory Very Week obligations? Do boards and their audit committees effectively oversee and regularly review the effectiveness Weak of the internal control systems? Audit committee Moderately Do boards establish audit committees? strong
Georgia Country Report – 2012 PAGE 15 of 37
Issues Score17 Are audit committees fully independent? Very Week
Do audit committees include at least one member with substantial auditing or accounting Weak experience? Incentives and compensation Remuneration policy Do boards and their remuneration committees effectively shape the compensation system of Moderately their banks? strong Is remuneration meritocratic and linked to firm and individual performance? Weak
Is senior executive compensation aligned with prudent risk management? Weak
Remuneration committee Moderately Do boards establish remuneration committees? strong
Are remuneration committees independent from management? Very Week
Transparency to the market and regulators Financial statements
Is IFRS required by law or regulation? Strong
Corporate governance
Do banks report regularly on corporate governance matters? Weak
Moderately Do banks publish key governance information on their website? strong Moderately Is disclosure proportionate to size, complexity, ownership structure and risk profile of banks? strong Transparency to regulators Can the supervisory authority obtain information about ultimate ownership and other corporate governance matters? Weak
Georgia Country Report – 2012 PAGE 16 of 37
C. Analysis of the strengths and weaknesses of the corporate governance of banks in Georgia
8) The strategic and governance role of the board
Key strengths
Legal framework
39. The Law on Entrepreneurs and the Law on Activity of Commercial Banks set out in detail the authority of the board. With regards to the strategic and governance role of the board, they include appointment of members of the executive body and its oversight. Boards are required to approve a number of policies, including foreign exchange, credit and investment policies and approve any new directions in bank's activity.
Supervisory framework:
40. Responses to the questionnaire indicate that banks communicate to the supervisor their corporate governance policies and the supervisor has the tools to address material deficiencies within a set timetable. These include setting a timetable for compliance and deciding on sanctions for non-compliance. Responses to our questionnaires indicate that such powers are “rarely” exercised.
Bank practice
41. The majority of the banks reviewed approves a multiyear business plan. Boards generally participate in the annual budget setting process: discuss the plan, approve the final budget and review its variances. In the majority of the banks reviewed, boards also revise the budget for non-budgeted revenues and expenses, and receive regular reports on budget implementation variances.
42. Boards generally appear to regularly receive information on external environment and its impact on bank operation and risk exposure. This is important for the board to be able to identify market conditions and trends that have a bearing on the bank's current or future strategy, budget and risk profile.18
43. With regard to the governance role of the board, responses to questionnaires and interviews indicate that a number of banks have adopted corporate governance policies outlining their system of governance. The same banks use the Corporate Governance Code for Commercial Banks approved by the Banking Association in 2009 as a reference. However, as noted below, banks do not report on their compliance with the Code.
44. Banks have also generally adopted codes of conduct and ethics. In some banks, the code was approved by the board, in others by shareholders. The codes of ethics appear to be well communicated within the banks, but not to the external stakeholders. It is not clear how the banks review and monitor compliance with their codes.
45. The survey highlighted that boards of subsidiaries systematically transposes decisions of the group to make sure that they become policies of the local bank. This is a good practice and the
18 Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010), Principle 8.
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Basel Committee recommends subsidiaries to adhere to the same internal governance values and policies as its parent company. It is further recommended that the board of the subsidiary should - within its own internal governance responsibilities - set its policies and evaluate any group-level decisions or practices to ensure that they do not put the regulated subsidiary in breach of applicable legal or regulatory provisions or prudential rules.19
46. The internal audit function in the subsidiaries reviewed seems to be sufficiently integrated with group internal audit function. Responses to questionnaires reveal that local chief internal auditors usually have an administrative reporting line to the chief executive and local supervisory board, but report directly to group’s chief internal auditor.
47. In accordance with Law on Entrepreneurs and the Banking Law, boards are in charge of appointing and replacing members of the management board. All banks claimed that their boards set performance objectives for senior management in line with bank strategy and review these annually.
Key weaknesses
Legal framework:
48. The Law on Entrepreneurs and the Banking Law gives banks a great amount of discretion to decide which authority to delegate to the board or to the management. This is fine, as long as banks attribute a strategic role to the board and do not overload it with operational matters, which would reduce its capacity to supervise the management.20 The law should set the framework for the division of authorities among the board and the management so as to ensure that the board has the overall responsibility for the bank, including approving and overseeing the implementation of the bank’s strategic objectives, risk strategy, corporate governance and corporate values. The board should also be responsible for providing oversight of senior management.21
Supervisory framework
49. In September 2009, the Georgian Banking Association ('BA') adopted a voluntary Corporate Governance Code for Commercial Banks. The Code is based on the “comply or explain” approach, according to which banks may either comply with the recommendations of the code, or if they do not comply, explain the reasons for such non-compliance. Although there is an extensive list of banks which undersigned the Code promising to adhere to it, in practice it was not possible to locate any “comply or explain” reports.
19 Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010). In some jurisdictions, in order to exercise its corporate governance responsibilities independently, the board of the subsidiary is expected to have an adequate number of qualified, independent non-executive board members, who devote sufficient time to the matters of the subsidiary. 20 Another extreme would be if the bank delegates most of strategic authority to the management (or to shareholders/group) leaving the supervisory board without a clear role or authority. 21 See Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010), Principle 1.
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50. During the interviews, the National Bank of Georgia mentioned that currently it does not closely monitor the corporate governance practices in banks, but it intends to give governance issues heightened attention in its supervisory process in the future. The NBG highlighted that:
"We are planning to require that banks disclose more corporate governance information to the public on their websites, such as governance structure of the bank, risk policies, information about the management."
This is an important step in ensuring effective corporate governance practices, since supervisors must have a keen interest in sound corporate governance as it is an essential element in the safe and sound functioning of a bank and may adversely affect the bank’s risk profile if good practices are not effectively implemented.
51. The supervisory authority rarely meets with the representatives of the parent bank and does not require the parent/group to provide the supervisor with a policy specifying the role of the parent/group in the decision making process of the subsidiary.
Best practices recommend that the board of subsidiary, within its own internal governance responsibilities, should set its policies and should evaluate any group-level decisions or practices to ensure that they do not put the subsidiary in breach of applicable legal and regulatory provisions or prudential rules. The board of the subsidiary should ensure that such decisions or practices are not detrimental to the sound and prudent management of the subsidiary; the financial health of the subsidiary; or the legal interest of the subsidiary’s stakeholders.22 It is also emphasised that, in reviewing corporate governance in the context of a group structure, supervisors should take into account the corporate governance responsibilities of both the parent company and subsidiaries.23
Bank practice
52. Until March 2012, the large majority stake in the largest bank in the country was owned by GDR holders. Disclosure of beneficial ownership to the NBG is due only when the ownership triggers the 10% threshold. The NBG confirms it is able to identify the beneficial ownership when necessary, but it has not checked the process yet. It is of outmost importance for the bank’s sound supervision that both the bank and the supervisory authority are confident of the integrity of the bank’s ownership structure (including the depository receipt structure). Timely and accurate public disclosure on beneficial ownership structure should be required and where this information is not known to the bank or may not be publicly disclosed, at a minimum it should be obtainable by regulatory and enforcement agencies.24
53. The survey highlighted that boards are not always in control of the bank strategy. In some banks, boards are not in charge of approving the multiyear business plan, while the boards of
22 See EBA Guidelines on Internal Governance (GL 44). Best practices further recommend the parent, in order to fulfil its internal governance responsibilities, to: (a) establish a governance structure which contributes to the effective oversight of its subsidiaries and takes into account the nature, scale and complexity of the different risks to which the group and its subsidiaries are exposed; (b) approve an internal governance policy at the group level for its subsidiaries, which includes the commitment to meet all applicable governance requirements; (c) ensure that enough resources are available for each subsidiary to meet both group standards and local governance standards; (d) have appropriate means to monitor that each subsidiary complies with all applicable internal governance requirements; and (e) ensure that reporting lines in a group should be clear and transparent, especially where business lines do not match the legal structure of the group. 23 See Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010) 24 See Basel Committee on Banking Supervision, Enhancing corporate governance for banking organisations (2006)
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other banks have not adopted written policy for strategy development and approval. Setting and overseeing the overall business strategy of the bank is among the key responsibilities of the board. Equally, it is a good practice for banks to have clear guidelines on the strategy approval process.
Recommendations
Legal framework
1. The Law on Entrepreneurs and/or banking regulation should guide the distribution of powers and responsibilities between the board and the management. Strategic decisions (e.g., approval of the strategy, budget and risk appetite) should belong to the supervisory board; whereas operational matters are best delegated to the management board.
2. Banks must monitor its shareholding structure with a view to ensuring that there is no potential for conflict of interest and that there are transparent relationships among shareholders and bank administrators. Banks should disclose such structure at least to the supervisory authority.
Supervisory practice
3. The supervisor should enhance its monitoring of banks corporate governance practices and consider encouraging banks to publish "comply or explain" reports in line with the Corporate Governance Code for Commercial Banks.
4. The supervisor should monitor if the boards of systemic important subsidiaries include sufficient checks and balances to ensure that subsidiaries do not blindly follow policies and practices imposed by the group. The supervisor should also promote its dialogue with the parent/group and have a clear understanding of the relationships between the group and the subsidiary boards and between key functions and businesses.
Bank practice
5. Boards should include local non-executive and independent directors to ensure objective judgement and robust knowledge of local rules, risks and legal interests of subsidiary's stakeholders.
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9) Composition and functioning of the board
Key strengths
Legal framework
54. The Law on Activity of Commercial Banks ('Law on ACB') and, in more detail, the Regulation on fit and proper criteria for administrators of commercial banks include fit and proper requirements for members of the management board, senior executives, chief accountants and heads of bank branches. The criteria are comprehensive and include requirements regarding education, banking, finance and managerial experience, financial soundness and probity. However, the Regulation expressly excludes from its application members of the supervisory boards and audit committee.
55. The Law on ACB prevents members of the SB from sitting on more than seven boards of companies registered in Georgia or the board of any other bank in Georgia, unless the latter is part of the group. This is to ensure that SB members can dedicate sufficient time to their functions and are not involved in competitive activities. Our analysis revealed that most banks’ SB non-executive directors sit on less than 5 external boards. It should be noted that this limitation applies only in relation to boards of companies registered in Georgia. This limitation should therefore be extended to all companies.
Supervisory practice
56. The NBG reviews the qualification, integrity and adequacy of appointed administrators (i.e., senior executives) after they have been approved by the bank. The bank is required to send all documents attesting the candidate’s compliance with the fit and proper criteria along with a statement by the candidate confirming compliance with the criteria and truthfulness of provided information. Should the NBG discover inadequacies in the administrator’s qualifications, the NBG has the authority to request its removal. Unlike the approach adopted in Georgia, in many countries in the region, the new executives may only begin acting after being approved by the supervisory authority. The Georgian approach is not necessarily an issue; it has the advantage of shifting the burden of proof on the bank and the administrator, does not interrupt the work of the bank and reduces opportunities for state undue interference. The same approach may be useful in screening the SB members.
Bank practice
57. Our analysis revealed that the size of the supervisory boards in the banks reviewed is comprised of less than 10 members, which seems to be a size that is fit-for-purpose. As the framework does not require presence of independent directors, bank practice in relation to appointing independent directors to the board varies widely. Exhibit 3 below represents the size and profile of the boards of three banks reviewed.
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Exhibit 3: Board profile of the three banks reviewed
58. In most banks, the chair of the supervisory board has held an executive position in the banking/financial industry in the previous 10 years. This is to ensure that the chair possesses an adequate balance of leadership skills and industry expertise.
59. Most banks also have an induction and continuous training programme for directors, to help board members acquire, maintain and deepen their knowledge and skills and to fulfil their responsibilities.
60. Our analysis revealed that most banks have established board committees. In some banks, committees have their own terms of references detailing their functions and responsibilities. However, there is little consistency in committees’ composition. Two of the three banks reviewed have no independent directors. Instead, for the purposes of insuring independence of the audit committee, banks tend to appoint “outsiders” (i.e., members who are not part of the SB or other governance bodies of the bank) as members of committees. The effectiveness of this practice is questionable.
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Exhibit 4: Board committees in the three banks reviewed
Board Audit (not part of Audit (part of SB) Risk Remuneration Nomination Committees SB)
Bank 1 X X X Bank 2 X X X X Bank 3 X X
Key weaknesses
Legal framework
61. Banking regulation includes very limited “fit and proper” requirements for supervisory board members, which cover only financial soundness. These do not refer to the moral probity, reputation, and competence of appointed persons. The NBG does not perform any review on the adequacy of the members of the SB. Best practices recommend that banking regulation require boards to possess, both as individual board members and collectively, appropriate experience, competencies and personal qualities, including professionalism and personal integrity. The board collectively should have adequate knowledge and experience relevant to each of the material financial activities the bank intends to pursue in order to enable effective governance and oversight.25
62. Similarly, there are no fit and proper rules for the members of the audit committee. During the interview with one of the banks, it emerged that none of the members in its AC have accounting or auditing experience. This is bad practice.26
63. The Law on Law on ACB allows executives to sit on the supervisory board of banks. Even if the Law provides some rules to mitigate possible conflicts of interest (e.g., the majority of the supervisory board should be non-executives and executives should be prohibited from participating in decisions related to the supervision of the management board), the solution provided is not ideal. In the two tier system, the oversight function is kept separate from the management one. Allowing members of one body to sit on the other does not make the system more effective and should be avoided.27
64. There are no requirements in relation to the position of chair of the board. The chair of the board plays a crucial role in the proper functioning of the board. It provides leadership to the
25 See Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010), Principle 2. 26 See Principles for enhancing corporate governance (2010), Basel Committee, § 51: At a minimum, the audit committee as a whole should have recent and relevant experience and should possess a collective balance of skills and expert knowledge - commensurate with the complexity of the banking organisation and the duties to be performed - in financial reporting, accounting and auditing. It is important that ACs possess such expertise to enable them to effectively review the work of the internal audit department and to set adequate accountancy policies 27 This issue is also addressed by the Corporate Governance Code for Commercial Banks, see “Combined Supervisory Board”, Chapter 4, letter c).
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board and is responsible for the board’s effective overall functioning, including maintaining a relationship of trust with board members. In this respect, the chair should possess the requisite experience, competencies and personal qualities in order to fulfil these responsibilities.28
65. Banking regulation does not require that there are independent members on the SB. Consequently, our analysis revealed that most banks do not have independent directors on their board and board committees. The Law on ACB includes a brief definition of independence for the purposes of the audit committee that equals independence with non-affiliation to the bank. The Corporate Governance Code for Commercial Banks includes a comprehensive definition of “independent member of the supervisory board”, but it does not seem that the code recommendations are considered by banks and only one among the banks reviewed includes independent directors on its SB. Board’s perspective and ability to exercise objective judgment - independent from executives and political or personal interests - should be enhanced by including qualified non-executive members on the board with a stature to be capable of exercising sound objective judgment.29
66. The banking regulation does not require banks to set up “board” committees and gives no guidance on the composition and role of such committees. Instead, the regulation requires banks to have an audit committee, which does not necessarily need to be comprised of supervisory board members but may be a separate body composed entirely of outsiders with no clear duties to the bank. The audit committee of one of the banks reviewed is composed entirely of outsiders; in another bank it is made of supervisory board members and outsiders, where none of them is independent. Only in one bank the audit committee is made entirely of independent board members (see exhibit 6 below).
67. The inclusion of outsiders on board committee needs to be carefully assessed.30 The key question here is what could a person that it is not a board member add to the debate? The discussion is open. First, we would argue that it is important that “board” committees include only “board” members if the functions delegated to the committee are typical “board” functions. Secondly, it is essential that those sitting on the committee and recommending specific actions, then follow up such recommendations by manifesting and voting on the committee’s recommendations at the board, therefore reinforcing their position and “objective judgement” as board members. Finally, committees made of outsiders rarely have the clout to compel access to information that would allow them to effectively challenge management. They might also create problems with confidentiality and accountability issues and. In this respect, it seems that audit committee members are not subject to the duties of care and loyalty applicable to the SB members. While, it is legitimate that the committee might need external advice or expertise on specific issues, it should be able to request such advice, but without leaving the advisor(s) to take the place of the committee in its decisions and recommendations. Once again, the Corporate Governance Code for Commercial Banks contains some useful guidance, which unfortunately does not seem to be followed.
28 Principles for enhancing corporate governance (2010), Basel Committee. 29 Id. 30 The arguments in favour of this approach are that non-board members would allow the audit committee to draw from a larger pool of industry and accounting expertise and that it might give the audit committee greater independence.
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Exhibit 5: Audit Committee composition in reviewed banks in Georgia
AC composition Bank 1 Bank 2 Bank 3
Independent SB 0 0 members Non-independent 0 0 SB members
Outsiders 0 (affiliated with majority shareholder)
Total
68. Responses to questionnaires and interviews indicate that company law and case law have not developed clear, robust standards for director duties of care and loyalty. Although the banking law describes duties of care and loyalty and sets responsibility rules, courts have not developed a consistent case law that defines director duties. It appears that such duties are mostly declaratory in nature and have never been applied in practice.
Supervisory practice
69. The NBG plays little role in the review of the adequacy of the members of the supervisory board and audit committee. Also, the lack of guidance in the banking regulation as to their composition creates an uneven playing field in bank practice in terms of the role, composition and responsibilities of these two bodies. The NBG is aware of the existing gap and agrees with the need to introduce some guidance in this regard.
“we prefer to observe the ways the banks organise themselves and to avoid strong interference from our side. Based on our observations we would then introduce regulations, but we see the gap in fit and proper requirements for the SB and AC members and plan to remedy this, mostly using soft leverage.”
Best practices recommend supervisors to evaluate whether the bank has in place effective mechanisms through which the board execute its oversight responsibilities. Supervisors are encouraged to meet regularly with individual board members, senior managers and those responsible for the control functions as part of the ongoing supervisory process.31
70. Responses to questionnaires and interviews indicate that the NBG does not encourage the presence of independent directors on boards and does not monitor the role and work of board committees. This goes against supervisory best practice, which recommend supervisors to evaluate whether the bank has in place effective mechanisms through which the board and senior management execute their oversight responsibilities. In addition to policies and processes, such mechanisms should include properly positioned and staffed control functions. Supervisors should assess the effectiveness of oversight of these functions by the board and
31 See Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010)
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meet regularly with individual board members – especially those that are independent - as part of the ongoing supervisory process.32
Bank practice
71. Banks generally do not have a nomination policy and have not established nomination committees. Best practices recommend banks to have an adequate number and appropriate composition of board members. In order to achieve this, boards should identify and nominate candidates and ensure appropriate succession planning in the board.33 A policy on the nomination and succession of individuals with key functions in the bank should be among the key responsibilities of the supervisory board. The policy should include a description of the necessary competencies and skills to ensure sufficient expertise in the board.34
72. The absence of a senior corporate secretary in the banks reviewed may weaken the link between boards and their committees. In fact, the corporate secretarial function in some of the banks reviewed is mostly administrative and limited in its reach. Corporate secretaries in some banks do not even participate in committee meetings; with some board committees appointing a secretary from members of senior managements. The audit committee is not supported by the corporate secretary but, for example, by the head of internal audit. In addition to preventing adequate flow of information, this creates conflicts of interest if the officials that report to the committees are also their secretaries.35
73. Boards do not generally carry out board evaluations. Our analysis revealed that the majority of banks do not conduct board evaluation and that very few engage the service of externally facilitated evaluations. The NBG confirmed the absence of such practice even if the Corporate Governance Code for Commercial Banks recommends this practice to all banks in Georgia.36 To support board performance, best practices recommend the board to carry out regular assessments of both the board as a whole and of individual board members. Assistance from external facilitators in carrying out board assessments can contribute to the objectivity of the process.37
Recommendations
Legal framework
1. Banking regulations should include fit and proper criteria for the supervisory board members and require boards to include a sufficient number of independent members. The definition of independent supervisory board member in the Corporate Governance Code for Commercial Banks should be given appropriate relevance and implementation.
2. The existing Corporate Governance Code for Commercial Banks should be given proper implementation. Alternatively, banking regulations should provide guidance on the role and composition of board committees, which should include only supervisory board members. The
32 Id. 33 Id. 34 See EBA Guidelines on Internal Governance (GL 44). 35 For guidance on the corporate secretary role and responsibilities, see ICSA Guidance on Corporate Governance Role of the Company Secretary: http://www.icsa.org.uk/assets/files/pdfs/081020%20- %20Corp%20Gov%20role%20of%20co%20sec.pdf 36 See Corporate Governance Code for Commercial Banks, Chapter 8, lett. a. 37 Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010), page 11.
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composition of audit committee should expressly provide for a sufficient number of independent and qualified supervisory board members.
Supervisory framework
3. The supervisory authority should monitor the composition of the supervisory board members and evaluate if the board is capable of discharging its duties.
Bank practice
4. Banks should develop nomination policies to be able to evaluate the skills necessary for their boards and regulate the selection process.
5. The board and committees should be supported by a corporate secretary of a reasonable seniority, responsible for ensuring the proper conduct of board and committee meetings.
6. Boards should carry out regular board evaluations to assess their effectiveness.
7. Subsidiaries should include in their supervisory boards sufficient number of persons with local expertise
10) Risk governance
Key strengths
Legal framework
74. Comprehensive regulatory requirements regarding the organisation of risk management in banks are contained in the Regulation on Risk Management (“Regulation RM”), adopted in 2008. The Regulation requires the SB to approve a risk management policy at least yearly and review reports from the management board on the policy’s implementation on a quarterly basis. The senior management is responsible for developing a risk management culture at all levels of the bank, monitoring the risk management policy implementation and regularly reviewing accuracy of methodology, adequacy of policies and procedures.
75. The Regulation RM requires that banks establish clear qualification requirements for the staff in the risk management unit. The Regulation RM also emphasizes the need for separation and independence of risk management and internal control functions from operational units.
76. Banks are encouraged to structure the risk management function in accordance with their needs, size and complexity. At the same time the Regulation RM requires that banks establish a risk management committee at the executive level, comprising the majority of management board members, and an independent risk management unit. The risk management committee is in charge of supervising implementation of the risk management policy and risk practices in the bank and consideration of external market factors with a view to adjusting the bank policy and practices if necessary. Thus the committee serves as a hub for a focused bank-wide perspective on risk practices of the bank.
Supervisory practice
77. For the purpose of implementation of the Regulation RM, banks were required to prepare an action plan with stages of implementation of new requirements and submit it to the NBG along
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with a report on the completion of each stage. Furthermore, banks must present to the NBG a quarterly risk profile report, as well as a report on any new product and new activity of the bank.
78. The NBG confirmed that it meets at least quarterly with key officials in risk departments of banks. The NBG also reviews the bank’s risk management systems during its inspections and can require additional reports and documentation, if the need arises.
Bank practice
79. Our analysis revealed that the majority of the boards of the banks reviewed receive regular and extensive reporting on the bank’s risk profile. Bank boards are generally regularly informed of concentration ratios in specific areas and sectors.
80. The banks reviewed have established a separate risk management function that operates independently. In line with Regulation RM, the risk management function is separate from the operation lines of the bank. The risk management function is in charge of identifying key risks and measuring the bank’s exposure to those risks. It participates in determining correspondent capital and in setting provisioning levels.
81. The analysis revealed that banks have generally established executive risk management committees. Some banks have also established an ALCO38 and a credit committee. In most cases, the heads of each key business lines, risk functions and legal department usually participate in the risk management committee’s meetings.
82. The analysis has also revealed that banks’ risk management function and system have generally been audited by an internal audit at least two to three times during the last 3 years.
Key weaknesses
Legal framework
83. The Regulation RM does not expressly provide that the supervisory board has the key responsibility to approve the general risk strategy of the bank. Instead, when describing the responsibilities for each type of risk, the Regulation ascribes to the board the responsibility to approve the strategy for such risk - as for example the strategy for market risk, or interest rate risk - but it is unclear with regards to the duty of the board to provide a general and forward looking risk statement for the bank. The Basel Committee strongly recommends that the board should approve the overall business strategy of the bank, as well as approve and oversee its implementation. This is an essential element in the supervisory role of the board.
84. The Regulation RM provides some guidance to banks on how to run stress-tests but it does not expressly require banks to perform stress-testing. The Regulation should envisage supervisory board discussion of the main assumptions for the bank’s wide stressing. Best practice emphasises that the board should have ultimate responsibility for the overall stress testing programme, whereas senior management is accountable for the programme’s implementation, management and oversight. This will help ensure the board’s and senior management’s buy-in
38 The 'Asset-Liability Committee - ALCO' is a risk-management committee in a bank or other lending institution that generally comprises the senior-management levels of the institution. The ALCO's primary goal is to evaluate, monitor and approve practices relating to risk due to imbalances in the capital structure.
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to the process. It will also help maximise the effective use of stress tests, especially with respect to firm-wide stress testing.39
Supervisory practice
85. The Regulation RM does not require banks to regularly submit to the NBG their risk management strategies and forward-looking risk statements. The NBG appears to be mostly interested in quarterly reports on the banks’ risk profiles, assessing the implementation of the strategy. This narrows the preventive role the supervisor should have in detecting weak risk management strategies at the early stages.
Bank practice
86. The analysis revealed that the supervisory boards in the majority of banks do not approve the bank’s risk appetite. Instead, the senior management are in charge of approving bank risk limits. Best practices recommend that the board should be responsible for approving the bank's risk strategy - including its risk tolerance/appetite - and for overseeing the implementation.40 This would ensure a clear top-down approach, guiding the senior management and avoiding potential conflicts of interest if senior management were to decide on bank risk limits (as its performance evaluation is too closely linked to risk taking and profitability of the bank). In case of a group, the board and management of a subsidiary should remain responsible for effective risk management processes at the subsidiary level and should have appropriate input into their local or regional adoption and to assessments of local risks. It follows that subsidiary should not be approving risk appetite but rather reviewing its implementation and adjusting it to fit business conditions and host supervisory expectations.
87. The analysis revealed that banks generally have a chief risk officer ('CRO') reporting to the CEO or management board, Often, the CRO does not have direct access to the board. Best practices suggest that the CRO must be independent, have sufficient stature within the bank and have direct access to the board. This independence and access by the CRO is not made clear in bank practice.41
88. Our analysis revealed that a few banks have in fact established a risk committee at board level. While boards should be allowed to determine the structure that best suits their needs, the establishment of a risk committee at the supervisory board level should ensure that there is adequate focus on the bank’s overall current and future risk tolerance/appetite and strategy, and on overseeing senior management’s implementation of that strategy. To guarantee the objectivity of this fundamental oversight function, the assignment of the committee’s chair to executives should be carefully considered.
89. From the analysis, it appeared that only few banks undertake stress-testing or report the results thereof to the NBG. Stress-testing in small and undiversified transition markets may not be
39 Principles of sound stress testing practices and supervision, Basel Committees on Banking Supervision, 2009, Principle1, see at: http://www.bis.org/publ/bcbs155.pdf 40 Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010), Principles 1 and 7. 41 For further guidance, see CEBS, High level principles for risk management (2010), page 4 (http://www.eba.europa.eu/documents/Publications/Standards---Guidelines/2010/Risk- management/HighLevelprinciplesonriskmanagement.aspx
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practical, however some discussion on what would go wrong in the context of the appetite discussion would be probably useful 42
Recommendations
Legal framework
1. The Regulation RM should be more specific in relation to the role and responsibility of the supervisory board in approving the general risk strategy and risk appetite for the bank.
Supervisory practice
2. The NBG should require supervisory board to adopt a forward-looking statement on risk (risk appetite). The risk appetite should be communicated to the NBG.
3. The supervisory authority should encourage banks to appoint a person responsible for the risk management function across the entire organisation (CRO) with sufficient independence and seniority to enable him/ her to challenge decision-making process of the institution and have direct access to the supervisory board.
Banking practice
4. Supervisory boards should be responsible for establishing the institution’s risk appetite and tolerance level - and for reassessing that level regularly - taking into account the information provided by the risk management function.
11) Internal control
Key strengths
Legal framework
90. Regulatory requirements regarding internal control in banks are found in Law on Activity of Commercial Banking and in the Regulation on Internal Audit (“Regulation IA”), which require banks to set up independent internal audit function. Furthermore, the Regulation IA sets out criteria for the education, experience and work ethics for the key officers in the internal audit department, including economic education, banking experience and familiarity with banking operations.
91. The Regulation IA emphasises the independence of the internal audit unit and establishes a direct reporting line for the unit to the audit committee of the bank. Thus the audit committee is responsible for reviewing the work of the internal audit unit, its staff appointment, dismissal and remuneration. The audit committee’s recommendations are sent to the supervisory board for approval. At the same time, the SB is prevented from taking any decisions regarding the internal audit unit and its staff without prior consent from the AC.
42 For further guidance, see CEBS Guidelines on Stress Testing (GL32), August 2010, available at: http://www.eba.europa.eu/documents/Publications/Standards---Guidelines/2010/Stress-testing- guidelines/ST_Guidelines.aspx
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92. The Regulation on Risk Management includes rules on the banks’ internal control systems. In particular, it requires the internal audit department to assess the effectiveness of internal control and risk management functions. The senior management must follow-up on the recommendations of the internal audit department and set deadlines for corrective measures.
Supervisory practice
93. When conducting on-site inspections, the NBG reviews the structure of internal audit function in banks. However, there is no obligation on banks to regularly report to the NBG on the effectiveness of their internal control systems.
94. The NBG indicated that banks regularly report related parties transactions, as well as relevant policies and inconsistencies with such policies.
Bank practice
95. Our analysis revealed that banks generally have organisation charts which are regularly reviewed and that the high-level decision-making authorities for the main businesses and control functions are mapped out and documented.
96. The analysis also revealed that the banks reviewed have set up internal audit functions, independent from other functions and responsible for reviewing the effectiveness of internal control systems, developing and implementing an audit plan, verifying management compliance with its recommendations and reporting to the supervisory board on internal matters. Additionally, banks require its internal auditors to coordinate their work with the external auditors.
97. The survey revealed that all banks reviewed have conflict of interest policies. Related parties’ transactions require notification and approval of shareholders.
Key weaknesses
Legal framework
98. Banking law and regulations require banks to set up audit committees, but provide little guidance in relation to the composition and expertise required. In particular the AC may include SB members as well as outside members (see discussion above). The Corporate Governance Code for Commercial Banks adopted by the Banking Association in 2009 provides some good advice on this issue. Unfortunately the Code does not seem to be properly implemented. Furthermore, the AC is appointed by the general meeting of shareholders ('GMS') and the AC final reporting line is the GMS - the AC has also a reporting line to the SB but it is perceived to be the watchdog for the GMS rather than a supervisory board committee. The AC appears to be a reminiscence of the so called "Revision Commission" which was included in the legislation of many countries in the region but over the years proved to be ineffective.43
99. The Regulation IA assigns the authority of approving the internal regulations of the internal audit department, its working plan and its staff to the audit committee. This structure bases the independence of the internal audit on the objectivity of the audit committee and is effective
43 The OECD-EBRD Policy Brief on Corporate Governance of Banks in Eurasia, recommend (page 31) “that national policy makers and regulators in jurisdictions that have the Revision Commission assess the effectiveness of this system in banks. If they do not seem to be functioning effectively, the option of removing them from any legislation, or, at least, repealing the mandatory requirement to establish them is strongly recommended”. See: http://www.ebrd.com/pages/sector/legal/corporate/eurasia.shtml
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only if the audit committee is a board committee made of independent non-executive directors, which is not the case in Georgia.44
100. The banking regulations do not require that banks set up separate compliance function. Although the Regulation RM states that banks should appoint a compliance director, the role and purpose for such director is not explained.
Supervisory practice
101. The NBG does not monitor the adequacy of audit committee members and does not review its work and effectiveness. Similarly, the NBG does not have a direct contact with the audit committees of the banks.
102. The supervisor does not currently monitor the existence of a potential for a conflict of interest in relation to the services provided by the external auditors. The NBG mentioned that it may:
"occasionally enquire with the banks what other services the external auditor provides to the bank"45.
However, the NBG did not appear concerned with the situation.
103. Until recently, the large majority of the largest bank in the country is held by GDR holders. The supervisory authority does not seem to have in place a clear procedure to monitor and identify the beneficial ownership of holders. This situation can cause potential conflict of interest and does not ensure the integrity of the bank’s ownership structure. In order to avoid this risk, the regulator should be able at all time to have a clear view of the ownership structure of the bank.
Bank practice
104. Banks generally do not establish compliance functions. The legal departments usually handle some of the relevant responsibilities of the compliance, but these are mostly driven by the anti money laundering quest. In smaller organisation, combination of the compliance function with the risk control or other support functions is acceptable, so far it is able to manage the bank’s compliance risk46, ensure that the compliance policy is observed and be able to speak directly to the board. The findings of the compliance function should be taken into account by the board and the risk control function within their decision-making process.
105. All banks reviewed confirmed that their external auditors actually perform services other than auditing. Moreover, banks do not have policies in place for the provision of non-audit services.
44 See also Corporate Governance of Banks in Eurasia (2008), by OECD and EBRD, p. 28-29 and the Basel Committee, Principles for enhancing corporate governance (2010), Principle 3. 45 Article 1.9 of the Georgian Regulation on External Audit of Commercial Banks states that an auditor and/or auditing firm that is conducting bank’s audit is prohibited from conducting any services, other than audit related services (except for tax services) for this bank, its subsidiaries or companies considered as the bank’s controlling or holding companies. An exception is allowed if the remuneration received from the non-auditing services is less than 5 percent of the auditor’s and/or auditing firm’s total annual income. Article 3.1.C states that the National Bank of Georgia can request the change of an auditor or an auditing firm if it believes that the auditor/auditing firm is conducting inadequate audit, is not independent, or does not comply with established professional standards. These provisions do not seem to be well implemented. 46 See in particular, EBA Guidelines on Internal Governance (GL 44), page 43. Compliance risk is defined as the current or prospective risk to earnings and capital arising from violations or non-compliance with laws, rules, regulations, agreements, prescribed practices or ethical standards) can lead to fines, damages and/or the voiding of contracts and can diminish a bank’s reputation.
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Corporate fraud and accounting scandals around the world have led to a heightened focus on the regulation of auditors, audit quality and especially auditor independence. The provision of non audit services by the external auditor can raise conflicts of interest and impair the independence of the auditor and the confidence in the audit. Some jurisdictions prohibit auditors from providing non auditing services to the entity they audit. Others allow it, but require due disclosure of the services provided so as to ensure that conflicts of interest do not arise. When these services are allowed, it is a good practice for the audited entity to adopt a policy on the provisions of non-auditing services so as to ensure the independence of the external auditor and the lack of conflicts of interest.
Recommendations
Legal framework
1. Banking regulation should clarify the supervisory board role in ensuring the effectiveness of the internal control system, independence of the internal audit function and monitoring implementation of the internal audit recommendations. The delegation of this authority to the audit committee should be coupled with the requirement that the audit committee is an independent “board” committee (i.e., made only of supervisory board members/non-executive directors where [at least] the majority is independent).
2. Banking regulation should clarify the role and composition of the audit committee in systemically important banks. In addition to supporting the board in ensuring the integrity of financial statements and the effectiveness of the internal control systems, audit committees should ensure the systematic and independent review of significant conflicts of interest, including related party transactions and should monitor accountancy policies. The regulation should also reflect best practice by leaving the decision powers with the board.
Supervisory Practice
3. The NBG should be able to have at all time a clear picture of the beneficial ownership structure of the banks, even when such shareholding is represented by Global Depository Receipt (GDR).
Bank practice
4. Banks should establish effective compliance function in charge of managing the bank’s compliance risk.
5. Banks should clearly disclose non auditing services provided by the auditor and adopt policies in this regard so as to avoid conflict of interest and ensure confidence in the external auditor’s independence. Banks might also benefit from rotating the external auditor on a regular basis.
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12) Incentives and compensation
Key strengths
Bank practice
106. Our analysis revealed that boards approve senior executive compensation, set guidelines and discuss the remuneration policy of the bank. Most banks have established board remuneration committees responsible for setting the parameters for the remuneration policy across the bank. These parameters are consistent with the bank’s culture, long-term objectives and strategy of the bank. The remuneration committees also exercise oversight over strategic human resources issues.
107. Most banks also include in their financial statements the amount of equity based compensation to their top management and the total amounts paid to key management personnel.
108. Our analysis revealed that between 40-70 percent of the total compensation to senior executives is variable. This is primarily linked to individual performance and less so to the bank’s performance and prudent risk management. Most banks indicated that 50% or more of the bonus is deferred for at least 2 years. This is an arrangement that, in principle, should align the compensation with the long term interest of the bank
Key weaknesses
Legal framework
109. The framework does not establish any rules regarding the remuneration policies in banks. In particular, it does not require banks to align their remuneration systems with prudent risk management and with the long-term objectives of the bank. Only the Corporate Governance Code for Commercial Banks recommends banks to take into account bank's corporate culture, long-term goals, and strategy and control environment when setting up its remuneration system. Unfortunately, the Code is not properly implemented.
Supervisory practice
110. The NBG does not monitor remuneration policies and does not seem to have a clear picture of the amount of variable compensation paid to executives. However, responses to interviews indicate that NBG is currently considering the possibility of including new reporting requirements.
Bank practice
111. In all banks reviewed the CROs are paid based on the same criteria as the senior executives. According to best international practice: "for employees in the risk and compliance function: remuneration should be determined independently of other business areas and be adequate to attract qualified and experienced staff; performance measures should be based principally on the achievement of the objectives of their functions."47
47 Compensation Principles and Standards Assessment Methodology, Basel, 2010, Principle 3 - Standard 2, see at: http://www.bis.org/publ/bcbs166.pdf
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Recommendations
Supervisory practice
1. The NBG should monitor executive remuneration and relevant bank policies, and require disclosure of the variable amount paid so as to be sure this is in line with the prudent risk management.
Bank practice
2. Banks should endeavour to link executives’ remuneration to prudent risk management and overall performance of the bank and use different criteria for the compensation of employees of the risk function.
13) Transparency to the market and regulators
Key strengths
Legal framework
112. Some level of transparency to the market is ensured through the requirement that financial institutions report be in accordance with IFRS. Board members and key executives are required to disclose transactions in their company's securities. The banking regulations also require banks to have their annual financial statements externally audited.
113. There is a separate regulation dealing with transparency of the financial information by the banks. The regulation explicitly requires banks to publish their financial statement on their websites and enumerates the type of financial information banks must publish.
114. The Corporate Governance Code for Commercial Banks recommends a wider scope for bank public disclosure, which should include bank ownership structure, bank goals and strategy, information on composition and background of MB, SB and board committees, the content and scope of transactions with related parties, information on general meeting of shareholders. 48 Banks practices partially reflect the Code's recommendations.
Supervisory practice
115. The NBG has full access to banks' books and records and has sufficient powers to request compliance with legal requirements regarding transparency of financial information. The NBG is confident that it can obtain information on ultimate ownership.
Bank practice
116. All three banks reviewed publish audited financial statements on their website. They also publish information on the composition of their supervisory and management boards. Banks also include in their Annual Reports disclosure of related parties transactions and most banks include compensation amounts to key bank executives.
48 see Georgian Corporate Governance Code for Commercial Banks, Principle 7.
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117. Banks also disclose on their websites the shareholders’ structure.
118. With regards to annual general meeting information, very few banks include relevant information on their website.
Key weaknesses
Legal framework
119. It appears that, apart from the financial statements, the current mandatory banking regulation do not require banks to make additional disclosures on corporate governance, ownership structure, director remuneration or report on effectiveness of internal controls. 49
Supervisory practice
120. Banks do not prepare annual reports on risk management along the lines required by Basel II, Pillar III. Additionally, the supervisory authority does not require from banks a corporate governance report which includes information on the functioning of the board, management and audit commission, current composition and work during the past period, a director remuneration report and a report on the effectiveness of internal controls. These are all important tools for adequate supervision that would allow the supervisor to understand how the processes in the banks are performed.
Bank practice
121. Banks do not disclose the names of the independent directors (if any), the structure of board committees, their composition, the education and background of their members, their terms of references, and the main activities undertaken during the year (i.e. number of meetings, attendance by members and issues considered and recommendations proposed).
Recommendations
Legal framework
122. Banking regulation should require systemically important banks to disclose the necessary information to enable the market and other stakeholders to understand their management, governance and ownership structure, through annual reports or on the bank’s website.
Supervisory practice
123. The NBG should require banks to submit annual reports on risk (ideally along the lines required by Basel II, Pillar III) enabling a better assessment of their risk profile and their capital adequacy;
49 "An institution should publicly disclose at least the following: a) its governance structures and policies, including its objectives, organisational structure, internal governance arrangements, structure and organisation of the management body, including attendances, and the incentive and remuneration structure of the institution; b) the nature, extent, purpose and economic substance of transactions with affiliates and related parties, if they have a material impact on the institution; c) how its business and risk strategy is set (including the involvement of the management body) and foreseeable risk factors; d) its established committees and their mandates and composition; e) its internal control framework and how its control functions are organised, the major tasks they perform, how their performance is monitored by the management body and any planned material changes to these functions; and f) material information about its financial and operating results.", see EBA Guidelines on Internal Governance (GL 44), page 46-47.
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on corporate governance; on director remuneration; and on the effectiveness of internal control system.
Bank practice
124. Banks should follow the recommendations of the Corporate Governance for Commercial Banks and disclose the detailed information on the education and experience of governance bodies, their structure functioning and responsibilities.
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